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Chapter 1


What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,

Why Derivatives Are Important

Derivatives play a key role in transferring risks in the
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
Many financial transactions have embedded

How Derivatives Are Traded

On exchanges such as the Chicago Board
Options Exchange in US market; Bursa
Malaysia Derivatives Bhd in Malaysia market
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other

How Derivatives are Used

To hedge risks
To speculate (take a view on the future
direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another

The Exchange
Bursa Malaysia Derivatives (BMD) offers 3
categories of derivatives:
- Commodity derivatives ( crude palm oil futures)
- Equity derivatives (FTSE KLCI futures, FTSE KLCI
options, single stock futures)
- Financial derivatives- 3-month KLIBOR futures, 3years MGS futures, 5-years MGS futures

Clearing house
BMD clearing house clears and settles
derivatives contract through derivatives
clearing and settlement system (DCS)
Allow market participants to deal freely with
each other without credit risk constraints.

Electronic Trading
Traditionally futures contracts have been
traded using the open outcry system where
traders physically meet on the floor of the
This has now been largely replaced by
electronic trading and high frequency
algorithmic trading is becoming an
increasingly important part of the market

Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
The forward price may be different for
contracts of different maturities (as
shown by the table)

The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell
has what is termed a short position


Futures Contracts
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC,
a futures contract is traded on an exchange


Exchanges Trading Futures

CME Group (formerly Chicago Mercantile
Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)


Over-the Counter Markets

The over-the counter market is an important
alternative to exchanges
Trades are usually between financial
institutions, corporate treasurers, and fund
Transactions are much larger than in the
exchange-traded market


A call option is an option to buy a certain
asset by a certain date for a certain price (the
strike price)
A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price)


American vs European Options

An American option can be exercised at any
time during its life
A European option can be exercised only at


Options vs Futures/Forwards
A futures/forward contract gives the holder
the obligation to buy or sell at a certain price
An option gives the holder the right to buy or
sell at a certain price


Types of Traders


Hedging Examples
A US company will pay 10 million for
imports from Britain in 3 months and
decides to hedge using a long position in a
forward contract
An investor owns 1,000 Microsoft shares
currently worth $28 per share. A two-month
put with a strike price of $27.50 costs $1.
The investor decides to hedge by buying 10

Value of Microsoft Shares with and

without Hedging


Traders can switch from being hedgers to
speculators or from being arbitrageurs to
It is important to set up controls to ensure that
trades are using derivatives in for their
intended purpose.